After more than three years of surging growth in trading volumes and profits, and a relentless rise in its share price, the London Stock Exchange has hit a brick wall. Since the beginning of this year shares in the LSE have plunged by more than a third. Has the party for the LSE, its indomitable chief executive Clara Furse and the rest of the exchanges sector, come to an abrupt end?

On paper, the LSE is firing on all cylinders. Last week it announced an 82% increase in electronic trading volumes in UK stocks, following a record month for trading in January. It has just a few weeks left until the end of its financial year, and is expected in May to announce record revenues and profits, having posted a 41% increase in half-year operating profits in November.

The exchange’s share price refuses to agree. Last Friday, its shares dropped briefly to 36% below where they were at the beginning of January, which puts the LSE somewhere between Citigroup (down 28% this year) and UBS (down 42%). Given that it is unlikely the exchange will be announcing billions of dollars in writedowns on sub-prime mortgages, what is going on?

The problem for the LSE and, to a lesser extent, other exchanges, is that it has been hit by a perfect storm of increasing competition, lower margins, questions over the intentions of some of its biggest shareholders, the collapse in the new issue market and a rerating of the US exchanges sector.
At the same time, some investors are concerned about the depth of its management bench if and when Furse, who has been battling away for more than seven years, steps down.

Of the 12 analysts covering the stock, just one rates it as a Buy, and last week analysts at Morgan Stanley and Sanford C Bernstein slashed both their price target and earnings forecasts for next year.
The LSE is not alone in watching its share price collapse and, after an almost absurd 49% rise between September last year and January after the Qatar Investment Authority and Dubai exchange took stakes of more than 20%, it had furthest to fall. Shares in NYSE Euronext have tumbled nearly 30%, while Deutsche Börse, Nasdaq and the CME are down by between 22% and 26%.

But this should not disguise the real challenges the LSE faces. First, the exchange is uniquely exposed to the rise of competition from alternative trading venues such as Turquoise, the platform set for launch in September backed by a consortium of nine investment banks, and Chi-X, which last week traded just under 10% of UK equities.

Morgan Stanley estimates that about 85% of the LSE’s revenues are related to equities and 36% directly to trading fees. While no one is forecasting a wholesale shift in liquidity away from the exchange, the latent threat of competition has forced it to cut its fees for its highest volume users, meaning that the continued surge in trading volumes no longer translates directly to surging profits.

Second, the LSE will be hit this year by the slowdown in initial public offerings, which have got off to their worst start in five years. While fees from new issues account for only a tiny percentage of the exchange’s revenues, this feeds through directly to the bottom line and the flow of international issues from China and Russia has all but dried up. Morgan Stanley forecasts a 40% decline in new issue revenues this year.

Third, and more important, is that the takeover speculation that has buoyed the LSE’s share price for more than three years has all but evaporated, to be replaced by fear of a big stock overhang. The biggest players in the world of exchanges, including the LSE after its acquisition of Borsa Italiana last year, are busy digesting recent deals.

Questions also remain over the intentions of Borse Dubai, which owns more than 20% of the LSE but which may be forced to sell the stake to help finance its $4bn (€2.61bn) acquisition of Scandinavian exchange OMX. The Italian banks that took another 20% of the stock last year after the acquisition of Borsa Italiana may also have to sell up because of pressures on their core business.

For good measure, Borsa Italiana’s performance is dragging down the LSE’s core business. While the value of trading in UK equities jumped 11% in February, the value of Italian equities dropped by 13%.

All of this is taking place against the backdrop of a rerating of the US exchanges sector, where earnings multiples have fallen from the mid-30s to mid-20s, mainly on the back of regulatory concerns in Washington over the structure of the big derivatives exchanges in Chicago. This in turn has dragged down relative valuations in Europe.

This leaves a more intangible question about Furse’s future. Several senior bankers in the equity markets have hinted she might be looking to move on after an outstanding seven years in charge. Nonsense, says the LSE, she is fully committed to delivering the synergies from the Borsa Italiana deal, which should start coming through later this year, and to facing down new challenges.

But given her record – on her watch the share price has quadrupled and she has fought off five unwanted bids – it would be more surprising if she had not been approached by a host of other companies for a bigger role. It may make sense to take one of those offers before the party comes to a grinding halt.